No time to panic

WITH upwards of $20 billion frozen in investment funds, money pouring out of foreign bank branch accounts, Wayne Swan telling retirees to visit Centrelink, and the Reserve Bank of Australia quietly going out of its mind, the Rudd Government had an impressive political victory this week.

This victory was stunning in its brazen simplicity: it was the Government's avoidance of political responsibility for the turmoil it had created in the finance sector where deposits were not guaranteed.

This was an exercise in damage containment, the power of incumbency and message control.

By yesterday the game was up. The facade was broken. The freezing of billions of dollars of investments in non-guaranteed institutions had become a grassroots political issue about to ignite and burn the Government.

Just in the nick of time, Treasurer Wayne Swan materialised in Brisbane, after the markets had closed, to announce a new mechanism that the Government hopes will solve the problem. Time will tell whether it works, whether it unfreezes the funds or whether a variation of this process will be repeated. Swan signalled that the Government will take more action if needed.

Over the past fortnight Swan had been increasingly anxious to resolve this dilemma. Behind the scenes he worked ferociously this week to secure a resolution to the turmoil. The solution he announced late yesterday was desperately needed and came after a meeting of the Council of Financial Regulators.

It came 12 days after the Government's decision that largely (but not totally) generated the crisis. It came a week after Reserve Bank governor Glenn Stevens told Treasury secretary Ken Henry in an email that "we have been going around and around on this stuff but I think we need to get something out to the markets soon". Well, that didn't happen. The turmoil ran for another week until it began to impinge on the small investor class.

But give Rudd and Swan their due. They exploited the politics of Parliament House brilliantly to deny and conceal the obvious: that the unlimited deposit guarantee decision of October 12 was seriously defective in its impact and that it had begun to disadvantage many Australians.

While the situation was complex, its origins were simple. Cabinet's emergency decision to guarantee without any limit all deposits of Australian banks, building societies, credit unions and Australian subsidiaries of foreign-owned banks (covering about $1.2trillion in funds overall) created two classes of investments, with those not covered by the guarantee - such as foreign banks, cash management trusts, mortgage funds and investment companies (upwards of $180 billion overall) - exposed to a possible run on their funds as some investors chased the guarantee.

The alarm of the Reserve Bank at the consequences of this decision was palpable and documented. The entire thrust of Stevens's October 17 message to Henry was the need to contain the government guarantee and charge for the guarantee.

He said "the more the guarantee is used, the bigger the problem elsewhere in the system" and he argued that "if domestic investors really do want the guarantee that much, they should be prepared to pay a lot: the riskless rate of return should fall".

This revelation was an embarrassment for the Government because the scheme it announced had no cap and no fees.

The Government's initial position was untenable and demanded substantive policy changes. In one sense this was hardly a surprise. In a global financial crisis you don't achieve perfection at the first attempt, and nobody expects this.

Rudd's October 12 announcement was driven by an overriding urgency: the need to save the stability of Australia's financial system given the global meltdown. This forced decisions that would normally be unthinkable. Rudd's action was based on Henry's advice about how to best protect Australia from the overseas panic. It is significant that Stevens, as central bank governor, was not at this meeting, nor was he directly consulted.

Henry told the Senate estimates committee this week that the Reserve Bank and Treasury were "of one mind" on the emergency response of an unlimited guarantee. But the regulators "noted there would be matters of detail to be sorted out in the implementation of the package".

These details created what Stevens soon called "serious dislocation in the financial system". From the moment the guarantee was canvassed, the Reserve Bank knew that such a guarantee would have unintended consequences. The key to events of the past fortnight is to realise that Treasury is the main adviser to the Government and that Henry conveys to ministers the views of the Council of Financial Regulators (including the bank) but that the central bank, closer to the markets, has been pushing for substantive changes to rectify the defects in the October 12 decision.

Stevens said the initial fees being canvassed with Treasury were too low. He insisted not only on a cap above which a fee should be charged but argued "the lower, the better". He was horrified at the initial idea of a $5 million cap, saying it was "incredibly generous".

In the end, Swan has settled on a $1 million threshold, above which a fee will be charged to receive the benefits of the deposit guarantee. Swan says this will ensure the guarantee does not provide disincentives to operate in the short-term money market. It has been apparent all week the Government would not set the guarantee below $1 million.

Rudd and Swan superbly contained the politics of this diabolical problem. Consider Swan's position. Desperate to have the regulators sort out the mess, he had to project a public aura of calm and control in the parliament this week while being utterly unable to provide material detail on any solution, given market sensitivities.

Rudd knew the deposit guarantee was popular politics. Why wouldn't it be? His constant refrain was that the Government had acted decisively and that the Opposition was playing a spoiling game. Rarely has the gulf between Canberra's artificial rhetoric and the market reality been more stark.

Returning to Canberra at the start of the week, Opposition Leader Malcolm Turnbull was ahead of the curve. Turnbull had warned on the ABC television program Insiders last Sunday about the "unintended consequences" of the decision. He was aware of growing problems in financial markets, the alarm of the Reserve Bank and the vulnerability of the Government on the issue.

Turnbull went on the attack when he read the first sentence of The Australian's lead story last Tuesday morning to the effect that the Reserve Bank governor had warned that the Government's "blanket guarantee" was creating "serious dislocation" in markets and "must be changed". As is documented, this sentence was 100 per cent correct.

The problem in the story was its implication that the bank did not give Rudd's October 12 deposit guarantee decision its imprimatur. Any idea of a split in the official family would be lethal at this time. Rudd denied this, and Henry, referring to this point, told the Senate estimates hearings this week the claim was wrong. However, this does not gainsay any central bank view that an unlimited deposit scheme would have unintended consequences.

Turnbull's fate was to spoil his excellent hand. The merit of the issue ran Turnbull's way but he lost the politics. The Opposition's mistake was to personalise the issue around Henry and Stevens. This was part accident, part madness.

The accident was Turnbull's miscalculation at question time on Tuesday when he asked Rudd whether, if Henry had incorrectly conveyed the bank's position on October 12, he would be sacked.

Turnbull was not calling for Henry's dismissal. It was a barrister's point and a political blunder. But there has been a history between Turnbull and Henry, and Rudd took the political opening he had been gifted.

It was reinforced by further Coalition follies. At the estimates committee on Wednesday, Senate Opposition deputy leader Eric Abetz questioned Henry's integrity during a long, tedious and counter-productive performance by Coalition senators who seemed to have lost the plot. The next day, Liberal MP Don Randall attacked Stevens and then had to write an apology.

The Coalition compulsion to finger Henry and Stevens is irrational. They are public officials of unquestioned integrity and competence. Australia's 17-year growth cycle that helped to keep the Howard government in office for so long was partly the product of official advice and decisions from the Treasury and Reserve Bank.

The upshot is that Rudd was able to engender a largely contrived issue, what he branded as Turnbull's attacks on the nation's economic institutions - the Treasury and the Reserve Bank - at a time of global crisis.

Rudd was fascinating this week. He went for Turnbull's throat. It is the start of a new phase of politics driven by the looming economic downturn facing Australia.

Rudd wants to destroy Turnbull's standing ahead of the downturn, knowing that if Turnbull's economic credibility remains strong when the downturn arrives then the Government faces a serious contest.

The bigger open-ended policy issue of the week is where the implication of the deposit guarantee will run. This is a huge and historic intervention in the market. Justified by the emergency, widely applauded and popular, now integral to Rudd's leadership, its consequences need to be bedded down by the market regulators. Consider Rudd and Swan - they are locked into a cycle of interventions to do whatever it takes to stabilise the system.